Question 2

An FI is planning to make a loan of $10,000,000 to a firm in the gas and oil industry. It expects to charge an annual servicing fee of 50 basis points. The loan has a maturity of 3 years and pays an annual fixed rate of 12 percent. The cost of funds (the RAROC benchmark) for the FI is 11.5 percent. The FI has estimated the maximum change in the risk premium on the gas and oil industry to be approximately 5 percent. The current market interest rate for loans in this industry is 12 percent per year.

a. Using the RAROC model, determine whether the FI should make the loan?

b. Assuming that the FI can modify the duration of the loan so that the loan could be approved, what is the new duration of the loan?

c. Assuming that the duration of the loan cannot be changed, how much additional fee income (in percentage) is necessary to make the loan to be approved?

d. Assuming that the duration and the interest and fee income of the loan cannot be changed, what is the maximum change in the risk premium on the gas and oil industry for the loan to be approved?